What's up with Deliveroo's share options? – FT Alphaville

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The most recent reports of Deliveroo’s valuation place it at around $2bn, which is good going for a five-year-old company. Naturally the investors who have bought shares at that price are expecting it to go even higher in the near future. After all, the venture capital game is about big bets and big profits. If Deliveroo meets the expectations of its backers, the $2bn mark should be just a quaint little step on its journey to massive value.

But when you look at the food delivery startup’s accounts, there is a surprising conservatism when it comes to its future prospects. The way Deliveroo calculates the value of the share options it gives to employees suggests the company is not expecting its share price to change very much at all over the next 10 years. The share price volatility it assumes is astonishingly low.

Now, before we go any further it is worth remembering that private company shares don’t have “volatility” in a meaningful sense. In the markets, historical volatility is a share’s average deviation from its average price over a given time. We’re going to talk about the “volatility” of Deliveroo’s shares, but it doesn’t really exist. The shares don’t trade, and they are only priced whenever the startup raises extra funding — this is not a publicly traded stock whose price jumps up and down throughout the day.

In accounting terms, however, it has to exist. Young, cash-hungry startups like to give their employees shares instead of money and so they need to be able to put a price on the share options they dole out. (A share option in this case is the right to buy stock in the future at a price agreed today.) The Black Scholes Model Deliveroo uses to calculate the value of its share options has a “volatility” input and so it’s not going to work unless someone estimates a number for that volatility and puts it in.

And the “volatility” also exists in a conceptual sense too. A company whose share price swings around a lot has a high volatility, and so that idea of high volatility kind of represents the level of uncertainty about its share price in the future. If it has a high volatility, then that means it’s difficult to predict what the share price will be next year, or in ten years time. And vice versa. If it’s difficult to predict the share price in the future, then the estimated volatility should probably be high.

If you’re a young, fast-growing, loss-making company whose model is yet to be proven, it’s reasonable to feel uncertain about the future share price. Yes, an investor might be bullish and expect the share price to be way bigger in the future, but putting a precise figure or range on it is harder than with, say, a utility company, which has relatively stable sales, cash flows and profits. As a result, you would expect to see a startup like Deliveroo using a relatively high number for its “volatility”.

But… it doesn’t! In fact, it uses a weirdly small number. Like, two per cent:

For those of you who know something about options, that is not a typo. For those of you who don’t, here’s some context on that two per cent figure.

Private companies often estimate their volatility by reference to comparable public stocks. The two most obvious comparables for Deliveroo are Just Eat and Delivery Hero.

Just Eat’s historical volatility for much of the last two years has been in the 25 per cent to 60 per cent range. Delivery Hero’s historical volatility since it went public this year has been in the 35 per cent to 45 per cent range. (Admittedly it was not trading back in 2016 when these options would have been granted.)

The 45 per cent volatility figure Deliveroo used in 2015 seems reasonable when compared to these publicly traded companies. The vastly reduced two per cent figure used in 2016 looks quite odd.

We can also look at the sort of publicly traded companies that are considered to have low volatility. For example, MSCI has an index of low volatility stocks — the BlackRock exchange traded fund that tracks the index has had a historical volatility as low as 4.4 per cent in recent years, but not two per cent. The historical volatility on Coca-Cola, which is one of Warren Buffet’s favourite stocks, has dipped as low as 6.8 per cent this year, which is low, but not two per cent. Or look at Centrica, the parent company of British Gas. Its historical volatility dipped down to 9.6 per cent in 2014, still some distance from two per cent.

Just to ram this point home, it’s worth thinking about what a two per cent volatility suggests. As mentioned above, the volatility of a stock is conceptually linked to the uncertainty about the future share price. When your volatility is as low as two per cent, the implication is that there’s a high degree of certainty about where the share price will be in the future.

In statistics, if the data you are looking at has a normal distribution, then there is a 68 per cent chance that any particular data point will fall within one standard deviation of the mean. The standard deviation is a measure of the dispersion from the mean. In the world of stock price prediction, this translates as ‘the future price at a given time has a 68 per cent chance of being within a certain percentage swing of the current price’. For a low volatility stock, this percentage swing will be small. For a high volatility stock, this percentage swing will be large.

Deliveroo’s options have a 10-year life, so we are effectively making a bet about the future price of the startup’s shares in ten years time. To scale the two per cent volatility figure over that time we multiply it by the square root of ten years, which leaves us with a number we can use for the standard deviation of approximately six per cent.

So a person pricing Deliveroo’s 10-year options with a two per cent volatility is effectively saying there is a 68 per cent chance that the startup’s share price in 10 years time will be just six per cent higher or lower than where it is now.

Think about that. This is a fast-growing company whose backers think they’re going to make many multiples of their money back. If Deliveroo’s investors thought the share price was only going to change six per cent over the next ten years, would they really be throwing tons of cash at it?

It should hopefully be clear by now that the two per cent figure is… use whatever synonym for bizarre you want.

A Deliveroo spokesperson told us that “volatility is based on the volatility of a peer group, so changes in the underlying volatility measures of the peer group have impacted these figures.” We asked why then the volatility was much lower than the likes of Just Eat, which would presumably be in its peer group and which, back when it was private, priced its own options with a volatility of around 20 per cent. The spokesperson told us the accounts were “fully audited and signed off by our board”.

From an accounting point of view, an option with a lower volatility is worth less than one with a higher volatility. This is because if a share swings around a lot, you are more likely to make a profit from your option. Your downside on an option is limited to the amount you paid for it, while your upside is the difference between the initially agreed price and the share price when you exercise it. So your losses are capped if the shares swing wildly down, but your profits are potentially unlimited if shares swing wildly up.

By calculating its options with a two per cent volatility, Deliveroo has reduced the value of the options it granted. By our calculation, using a 2 per cent volatility makes the average option four times less valuable than if the 45 per cent volatility estimate from 2015 was used.

This doesn’t seem like a great deal given the context of the £4.4m of share grants in 2016 and losses of £129m, but it might mean something to the people receiving the options.

Related links:
Is Deliveroo an ‘Amazon’? — FT Alphaville
When VCs get two bites of the apple — FT Alphaville
The minimum price a founder can sell their company for — FT Alphaville

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